Certain risks and concentration

12 Months Ended

Dec. 31, 2018

(a)

PRC regulations

Foreign ownership of internet-based businesses is subject to significant restrictions under the current PRC laws and regulations. The PRC government regulates internet access, the distribution of online information and the conduct of online commerce through strict business licensing requirements and other government regulations. These laws and regulations also limit foreign ownership in PRC companies that provide internet information distribution services. Specifically, foreign ownership in an internet information provider or other value-added telecommunication service providers may not exceed 50%. Foreigners or foreign invested enterprises are currently not able to apply for the required licenses for operating online games in the PRC. The Company is incorporated in the Cayman Islands and accordingly, the Company is considered as a foreign invested enterprise under PRC law.

As mentioned in Note 1(d), in order to comply with the PRC laws restricting foreign ownership in the online business in China, the Group operates the online business in China through contractual arrangements with its principal VIEs, namely Guangzhou Huaduo and Guangzhou Huya. As of December 31, 2018, Beijing Tuda and Guangzhou Huaduo own the majority equity interests of Guangzhou Huaduo and Guangzhou Huya, respectively.

Guangzhou Huaduo and Guangzhou Huya hold the licenses and permits necessary to conduct its internet value-added services and online advertising in the PRC. If the Company had direct ownership of the VIE, it would be able to exercise its rights as a shareholder to effect changes in the board of directors, which in turn could affect changes at the management level, subject to any applicable fiduciary obligations. However, under the current contractual arrangements, it relies on the VIE and its shareholders’ performance of their contractual obligations to exercise effective control. In addition, the Group’s contractual agreements have terms range from 10 to 30 years, which are subject to Beijing Huanju Shidai and Huya Technology’s unilateral termination right. Under the respective service agreements, Beijing Huanju Shidai and Huya Technology will provide services including technology support, technology services, business support and consulting services to Guangzhou Huaduo and Guangzhou Huya, respectively, in exchange for service fees. The amount of service fees payable is determined by various factors, including (a) a percentage of Guangzhou Huaduo and Guangzhou Huya’s revenues or earnings, and (b) the expenses that Beijing Huanju Shidai and Huya Technology incur for providing such services. Beijing Huanju Shidai and Huya Technology may charge up to 100% of the income in Guangzhou Huaduo and Guangzhou Huya and a multiple of the expenses incurred for providing such services, as determined by Beijing Huanju Shidai and Huya Technology, respectively, from time to time. The service fees payable by Guangzhou Huaduo and Guangzhou Huya to Beijing Huanju Shidai and Huya Technology are determined to be up to 100% of the profits of Guangzhou Huaduo and Guangzhou Huya, with the timing of such payment to be determined at the sole discretion of Beijing Huanju Shidai and Huya Technology. If fees were incurred, it would be significant to the Company and the operating companies’ economic performance because it will be incurred and paid at up to 100% of the earnings of the VIE. Fees incurred would be remitted, subject to further PRC restrictions. None of the VIEs or their shareholders are entitled to terminate the contracts prior to the expiration date, unless under remote circumstances such as a material breach of agreement or bankruptcy as it pertains to the service and business operation agreements and their amendment.

For the years ended December 31, 2016, 2017 and 2018, the Company’s wholly owned foreign enterprises determined that service fees of RMB305,792, RMB279,828 and RMB744,339 were charged to the Group’s VIEs, respectively.

Further, the Group believes that the contractual arrangements among Beijing Huanju Shidai, Huya Technology and Bilin Changxiang, the VIEs, and their shareholders are in compliance with PRC law and are legally enforceable. However, there are substantial uncertainties regarding the interpretation and application of PRC laws and regulations including those that govern the contractual arrangements, which could limit the Group’s ability to enforce these contractual arrangements and if the nominee shareholders of the VIEs were to reduce their interests in the Group, their interest may diverge from that of the Group and that may potentially increase the risk that they would seek to act contrary to the contractual arrangements.

In March 2019, the National People’s Congress enacted PRC Foreign Investment Law which would be effective starting from January 1, 2020. The Foreign Investment Law does not explicitly classify contractual arrangements as a form of foreign investment, but it contains a catch-all provision under the definition of “foreign investment,” which includes investments made by foreign investors through means stipulated in laws or administrative regulations or other methods prescribed by the State Council. Existing laws or administrative regulations remain unclear whether the contractual arrangements with variable interest entities will be deemed to be in violation of the market access requirements for foreign investment under the PRC laws and regulations. However, the possibility that such entities will be deemed as foreign invested enterprise and subject to relevant restrictions in the future shall not be excluded. If VIEs fall within the definition of foreign investment entities, the Group’s ability to use the contractual arrangements with its VIEs and the Group’s ability to conduct business through the VIEs could be severely limited. The Group’s ability to control the VIEs also depends on the power of attorney that the wholly owned subsidiary of the Group has to vote on all matters requiring shareholder approval in the VIEs. As noted above, the Group believes these power of attorney are legally enforceable but may not be as effective as direct equity ownership. In addition, if the Group’s corporate structure and the contractual arrangements with the VIEs through which the Group conducts its business in the PRC were found to be in violation of any existing or future PRC laws and regulations, the Group’s relevant PRC regulatory authorities could:

• revoke or refuse to grant or renew the Group’s business and operating licenses;

• restrict or prohibit related party transactions between the wholly owned subsidiary of the Group and the VIE;

• impose fines, confiscate income or other requirements which the Group may find difficult or impossible to comply with;

• require the Group to alter, discontinue or restrict its operations;

• restrict or prohibit the Group’s ability to finance its operations, and;

• take other regulatory or enforcement actions against the Group that could be harmful to the Group’s business.

The imposition of any of these restrictions or actions could result in a material adverse effect on the Group’s ability to conduct its business. In such case, the Group may not be able to operate or control the VIEs, which may result in deconsolidation of the VIEs in the Group’s consolidated financial statements. In the opinion of management, the likelihood for the Group to lose such ability is remote based on current facts and circumstances. The Group’s operations depend on the VIEs to honor their contractual arrangements with the Group. These contractual arrangements are governed by PRC law and disputes arising out of these agreements are expected to be decided by arbitration in the PRC. The management believes that each of the contractual arrangements constitutes valid and legally binding obligations of each party to such contractual arrangements under PRC laws. However, the interpretation and implementation of the laws and regulations in the PRC and their application to an effect on the legality, binding effect and enforceability of contracts are subject to the discretion of competent PRC authorities, and therefore there is no assurance that relevant PRC authorities will take the same position as the Group herein in respect of the legality, binding effect and enforceability of each of the contractual arrangements. Meanwhile, since the PRC legal system continues to rapidly evolve, the interpretations of many laws, regulations and rules are not always uniform and enforcement of these laws, regulations and rules involve uncertainties, which may limit legal protections available to the Group to enforce the contractual arrangements should the VIEs or the nominee shareholders of the VIEs fail to perform their obligations under those arrangements.

The following consolidated financial information of the Group’s VIEs excluding the intercompany items with the Group’s subsidiaries was included in the accompanying consolidated financial statements as of and for the years ended:

	December 31,
	2017		2018
	RMB		RMB
Assets
Current assets
Cash and cash equivalents		1,343,731		4,665,938
Short-term deposits		3,400,000		2,100,000
Restricted short-term deposits		1,000,000		-
Short-term investments		124,550		979,052
Accounts receivable, net		149,958		192,932
Inventory		315		-
Amounts due from related parties		9,309		172,258
Financing receivables, net		-		725,336
Prepayments and other current assets		190,456		663,437
Total current assets		6,218,319		9,498,953

Non-current assets
Long-term deposits		-		1,000,000
Deferred tax assets		113,017		70,834
Investments		582,775		862,272
Property and equipment, net		359,912		655,402
Intangible assets, net		15,504		57,050
Land use rights, net		1,832,739		1,784,639
Amounts due from related parties		20,000		-
Other non-current assets		133,812		143,240
Total non-current assets		3,057,759		4,573,437

Total assets		9,276,078		14,072,390

Liabilities
Current liabilities
Accounts payable		67,817		112,167
Deferred revenue		757,244		950,816
Advances from customers		80,406		101,690
Income taxes payable		142,204		162,118
Accrued liabilities and other current liabilities		1,404,877		2,207,138
Amounts due to related parties		30,502		28,336
Total current liabilities		2,483,050		3,562,265

Non-current liabilities
Deferred revenue		52,185		86,977
Deferred tax liabilities		8,404		-
Total non-current liabilities		60,589		86,977

Total liabilities		2,543,639		3,649,242

	For the year ended December 31,
	2016		2017		2018
	RMB		RMB		RMB

Net revenues		8,164,100		11,577,104		15,740,097
Net income		1,874,435		2,766,279		3,475,109

	For the year ended December 31,
	2016			2017			2018
	RMB			RMB			RMB

Net cash provided by operating activities		2,538,836			3,974,085			4,672,879
Net cash used in investing activities		(1,313,002	)		(3,571,668	)		(1,212,622	)
Net cash provided by financing activities		8,508			66,875			-
		1,234,342			469,292			3,460,257

(b)

Foreign exchange risk

The revenues and expenses of the Group’s entities in the PRC are generally denominated in RMB and their assets and liabilities are denominated in RMB. The Group’s oversea operation and financing activities are denominated in U.S. dollars. The RMB is not freely convertible into foreign currencies. Remittances of foreign currencies into the PRC or remittances of RMB out of the PRC as well as exchange between RMB and foreign currencies require approval by foreign exchange administrative authorities and certain supporting documentation. The State Administration for Foreign Exchange, under the authority of the People’s Bank of China, controls the conversion of RMB into other currencies.

(c)	Credit risk

Assets that potentially expose the Group to credit risk primarily consist of cash and cash equivalents, short-term deposits, long-term deposits, short-term investments, accounts receivable, financing receivables, amounts due from related parties, prepayments and other current assets.

As of December 31, 2017 and 2018, substantially all of the Group’s cash and cash equivalents, short-term deposits, short-term investments and long-term deposits were placed with the PRC and international financial institutions. Management chooses these institutions because of their reputations and track records for stability, and their known large cash reserves, and management periodically reviews these institutions’ reputations, track records, and reported reserves. Management expects that any additional institutions that the Group uses for its cash and bank deposits will be chosen with similar criteria for soundness. Nevertheless under the PRC law, it is required that a commercial bank in the PRC that holds third party cash deposits should maintain a certain percentage of total customer deposits taken in a statutory reserve fund for protecting the depositors’ rights over their interests in deposited money. PRC banks are subject to a series of risk control regulatory standards; PRC bank regulatory authorities are empowered to take over the operation and management of any PRC bank that faces a material credit crisis. The Group believes that it is not exposed to unusual risks as these financial institutions are either PRC banks or international banks with high credit quality. The Group had not experienced any losses on its deposits of cash and cash equivalents and term deposits during the years ended December 31, 2016, 2017 and 2018 and believes that its credit risk to be minimal.

The risk with respect to accounts receivable is mitigated by credit evaluations the Group performs on the payment platforms, game platforms, customers and the ongoing monitoring process of outstanding balances.

The Group is exposed to default risk on its financing receivables. The Group conducts credit evaluations of customers in finance business, either on an individual or collective basis. The Group also considers the value of collateral assets when assessing the collectability of certain financing receivables. Credit risk is controlled by the application of credit approvals, limits and monitoring procedures.

Amounts due from related parties, prepayments and other current assets are typically unsecured. In evaluating the collectability of the balance, the Group considers many factors, including the related parties and third parties’ repayment history and their credit-worthiness. An allowance for doubtful accounts is made when collection of the full amount is no longer probable.